Talk Drives the Unwinding of FX Positions

After relatively large moves in the foreign exchange market since nearly the start of the year, participants were particularly vulnerable to commentary that encouraged a reversal of trend. Japan's Amari got the ball rolling, suggesting that the yen's decline has been sufficient and that excessive strength had been corrected. This encouraged a bout of short-covering and took some shine off the other major currencies as cross positions were unwound.

Then Juncker's comments hit in the North American afternoon yesterday, claiming that the euro's exchange rate was dangerously high. Again the market's reaction was more about positioning than about the policy signal. Part of the demand, after all, for the euro has been coming from some of the largest asset managers returning to the Spanish and Italian bond markets, believing that the Open Market Transaction scheme is indeed a viable backstop.

The spirit of Amari's comments seemed to have been echoed by the LDP's Secretary General Ishiba, who, speaking before the business lobby noted that a yen that was too weak also posed concerns. This reinforced that sense that after having engineered a break in the yen's uptrend, without selling a single yen and antagonizing Japan's trading partners, officials were trying to blow air underneath the parachute to allow a soft landing to the yen. Yet Japanese officials seemed to be surprised by the pace of the yen's decline and Cabinet Secretary Suga came out and cautioned reading too much into Ishiba's comments.

The pushmi-pullyu tactics has contributed to market confusion and higher volatility. As the yen declined since mid-November, when the election was called, 3-month dollar-yen (implied) volatility has risen from 7% to almost 11% yesterday. The pullback in the dollar has not coincided with lower volatility.

Comments by Juncker, who will soon be stepping down as Eurogroup head, are different. His comments seemed largely one-off and have been countered by ECB's Nowotny (Austria) who said the current bilateral exchange rate against the dollar was not a concern and cautioned against emphasizing short-term fluctuations. That said, within Nowotny's comments are a vague hint that the assessment could change if the euro continued to appreciate (which he did not expect).

Germany's Economic Minister and FDP head Roesler's comments more directly took exception with Juncker's comments. When asked by reporters if he agreed with Juncker's assessment, he was quoted saying "No, I don't see that".

If the yen and euro moves have been driven by comments pointing in a direction contrary to short-term market positioning, the Swiss franc's story different. Speculation that the SNB may still resort to negative rates, or raise the euro floor. Neither scenario seems particularly likely at this juncture. There is not compelling reason to change tactics. The SNB did not appear to have to intervene in December and the market has done some heavy lifting for it. In less than 5 sessions, the euro has rallied 2.7% against the franc, lifting it through last year's highs to above CHF1.24.

The benefits of changing the euro floor to CHF1.25 from CHF1.20 does not seem worth the risks and costs. Franc bears will likely turn more cautious as the CHF1.25 area is approached in any event. There are some ideas that the SNB will look for an opportunity to unwind some of its foreign currency holdings. We are suspicious of its ability to do so secretly and hence do not expect it either. Moreover, we would expect it not to be triggered until the risk of deflation has subsided.

It is another full slate of US economic reports. However, given QE3+, the economic data, including CPI, are unlikely to be market movers, even if there is disappointment. For an impressionistic sense of the state of the economy, the Beige Book is probably the most important. Economists are still fine tuning Q4 GDP forecasts, which seem to be coming in around half the Q3 pace of 3.1%. Note too that the earnings reports from among the largest US banks are also out today.